Chapter 9
To Roth or Not to Roth
IN THIS CHAPTER
Mixing crystal balls and tax rates
Listing reasons not to Roth
Withdrawing from your Roth IRA before retirement
Switching to a Roth
A Roth IRA is a savings and investment account like a traditional IRA, except you pay taxes on the amount you put in, the money grows tax-free, and, if you follow the rules, you don’t pay any taxes on the investment gains when you withdraw funds.
Perhaps I should note up front that it doesn’t make any difference to me which type of IRA you choose. My sole objective is to give you information to help you make a decision.
Even if you don’t pay any federal income tax now, so that your future tax rate is bound to be higher and a Roth IRA seems a sure bet, review this chapter before you conclude that you want to go with a Roth IRA. Life’s uncertainties are one reason I recommend taking advantage of pre-tax opportunities to save for retirement via your 401(k) or a traditional IRA rather than after-tax Roth savings. Roth IRAs have some definite advantages; however, they are oversold as a huge tax break.
When I mention Roth contributions in this chapter, that includes Roth IRAs and Roth 401(k) contributions. When I mention pre-tax savings, that includes both a traditional IRA and 401(k) pre-tax contributions.
Predicting Future Tax Rates
It amazes me that some of the most popular financial gurus ask the question: “Do you expect tax rates to be lower or higher when you retire?” These advisors act as if the future tax rate is the only thing that matters when deciding whether to utilize an after-tax Roth IRA rather than a traditional pre-tax IRA. Most people expect tax rates to be higher in future years than currently, but they may or may not be right.
You need to answer many questions about the future, other than unknowable future tax rates when deciding whether to use pre-tax or after-tax contributions when saving for retirement.
Many states have legislation requiring employers that don’t have retirement plans to start one. Most of these states are setting up state-run plans for employers to adopt, making it easier for them to comply. Some state-run plans offer only Roth IRAs, which adds to the perception that these must be better than pre-tax IRAs. States certainly aren’t unbiased because those in office prefer collecting tax revenue now rather than later. The same is also true at the federal level. Governmental entities would rather get your taxes now than many years from now.
Calculating accurately
Many examples that show a Roth IRA having a big advantage usually compare $6,000 deposited each year into both a traditional pre-tax IRA and a Roth IRA. Such examples ignore the fact that you must pay taxes up front on what you contribute to a Roth IRA.
Assume you have $6,000 of income you want to save for retirement. With Roth contributions, you have to pay income tax on that amount. For the purpose of this example, say your marginal tax rate is 22 percent. You also have to pay state income and local wage taxes. Assume the combined state income and local wage taxes are 8 percent (your rate may be much higher). Because your state and local taxes reduce your federal taxes a bit, your combined effective tax rate is approximately 29 percent.
After paying 29 percent of the $6,000 in taxes, you actually have only $4,260 to put into your Roth IRA account. If both the $6,000 and the $4,260 receive the same investment return, the $6,000 invested each year will be 29 percent more than the $4,260 at the end of the investment period, which is probably your retirement.
Applying a 29 percent tax rate at the time of withdrawal to the larger $6,000 accumulation results in the same after-tax amount as the $4,260 with the Roth contributions. You will have the same amount left after paying tax during your retirement years as you would if you made after-tax Roth contributions during all the years you were saving for retirement.
The best way to build your nest egg is by contributing $6,000 per year to a pre-tax IRA rather than $4,260 to a Roth IRA. For sure your nest egg will be growing 29 percent faster each year in this example. The difference is even bigger for those who are in a higher tax bracket. This puts you in a much better position if your intended plans are disrupted.
Solo entrepreneurs and other self-employed individuals can get an even bigger tax break by setting up an employer-funded plan. Check out more about retirement plans for the self-employed in Chapter 18.
Talking tax breaks
If you don’t pay any federal income taxes, you have nothing to lose at the federal level by making Roth contributions; however, your state wage taxes may be high enough that you need to take that into account.
There is a widely held perception that a Roth IRA provides a huge tax break because you never have to pay taxes on the investment gains. The reality is that you get a federal income tax break only if your marginal tax rate is higher when you take your money out of the IRA than your marginal tax rate when you put the money in. So, if your tax bracket is lower when you withdraw your money, then you’ve lost. Making Roth contributions results in less taxes only if you have a higher marginal tax rate after you retire than before you retire.
If you start with Roth contributions, you may want to consider changing to pre-tax IRA contributions if your income increases and pushes you into a higher tax bracket.
Inflation, when prices go up, is another point to consider because inflation decreases the value of money. You can’t buy as much when prices increase; therefore, $1 of tax savings now is worth much more than $1 of taxes paid 30 years from now unless the economy experiences deflation rather than inflation.
Unless you don’t pay any federal income taxes now or you expect to accumulate millions of dollars in pre-tax savings by the time you retire, Roth IRA or Roth 401(k) contributions may not be your best option. The one exception is if you’re expecting a large inheritance — or planning to win the lottery. A large chunk of money may push you into a higher tax bracket then and make a lower tax payment now a no-brainer.
The “Or Not to Roth” Section
I always take any tax break I can get now rather than worrying about future tax rates because the future is too unpredictable. Your personal situation can change in so many ways over a 20-plus-year period including your marital status, health, employment, and so on. Expecting things to continue over a 20-to-30-year period without any disrupting events isn’t a good idea. I strongly recommend building your nest egg faster rather than slower because life is so unpredictable.
There’s no guarantee the Roth tax exemption will still be available when you retire. It’s certainly possible that Congressional members will decide at some point that they gave too big a tax break with the Roth IRA and levy taxes on the currently untaxed portion.
Social Security is a good example of changing tax rules. Social Security benefits weren’t taxable until 1984. Today, you can pay tax on up to 85 percent of your Social Security benefit — even though you pay federal income taxes on the amount you contribute to Social Security during all the years you work.
This comment used to get people attending my speaking engagements turning their heads, so let me explain: Both your federal income tax and Social Security taxes are computed as part of your gross income. This means you pay federal income tax on your Social Security taxes when you are working and paying them in. You also may have to pay taxes on 85 percent of your Social Security benefits after you retire. Not what I call fair.
Matching employer contributions are another factor if you’re fortunate enough to get them. For example, if your employer matches the first 6 percent of your pay, it’s easier to contribute this amount through your pre-tax 401(k) deferral than with 401(k) Roth contributions. You give up money from your employer when you don’t contribute the maximum amount that is matched.
It’s highly unlikely that tax rates will increase to a point where your tax rate on the substantially lower amount of taxable income you have after you retire will be higher than your current tax rate.
Taking Money Out of Your Roth IRA
You have reasons for saving other than retirement. Legislators realize that, which is why they added terms for withdrawing funds from a 401(k) in 1987. Roth contributions have an advantage if you need to withdraw them early in that your Roth contributions aren’t taxable when you withdraw them. Find more information on preretirement withdrawals in Chapter 16.
Roth contributions to a 401(k) may be withdrawn at any time if your plan permits.
The contributions you made to the Roth IRA aren’t taxable when you withdraw them. That said, you must also withdraw a pro-rata portion of your investment gains when you withdraw any portion of your Roth contributions. So, say you have $8,000 of Roth contributions to your 401(k) and those contributions have earned $2,000. Now you want to withdraw $6,000 to buy your first home. You’re withdrawing 60 percent of the $10,000 total. For tax purposes, the withdrawal equals 60 percent of your $8,000 contributions, or $4,800, and 60 percent of the $2,000 of investment gains, which is $1,200. The $4,800 isn’t taxable but the $1,200 is.
You also have to pay a 10 percent penalty tax on the $1,200 unless it is a qualified withdrawal. To be qualified you must have been making Roth contributions for at least five years and be over age 59½. This means if you’re 30 years old, you pay tax on the $1,200 plus a 10 percent penalty tax.
The way to minimize the tax impact when you take money out of a 401(k) for a first-time home purchase is to withdraw the money at the beginning of a year and to complete the home purchase shortly thereafter. The tax deduction for mortgage interest, state, and local taxes should more than offset the taxes triggered by the 401(k) withdrawal. Even better, your employer may have added to your 401(k) account via matching contributions, putting you much farther ahead by participating in the 401(k) rather than waiting until after you’ve saved enough outside the plan to buy the home.
Different rules apply to first-time homebuyers when withdrawing money from a traditional or Roth IRA. With a traditional IRA you (and your spouse, if you have one) may withdraw up to $10,000 for your first primary residence without having to pay the 10 percent penalty tax. You still have to pay tax on the amount withdrawn, but you don’t have to pay a penalty.
For IRA purposes, you’re considered a first-time homebuyer if you (and your spouse) haven’t owned a home during the preceding two years. You may qualify as a first-time buyer even if you own a vacation home or have an interest in a time-share. You can also withdraw money to help a child, grandchild, or parent buy their first home even if you own a home.
The five-year rule applies to a Roth IRA: You can withdraw all your contributions and up to $10,000 of the investment gains without paying any tax if your account is at least five years old. If your account is less than five years old, the investment gains you withdraw are taxable; however, the 10 percent penalty tax will not apply.
Converting to Roth
You can convert pre-tax 401(k) contributions, including any employer contributions and pre-tax money in a traditional IRA, into a Roth IRA. Conversions within a 401(k) are possible only if your plan permits you to do so.
You will be able to do so after you leave your employer or after you reach age 59½ if the plan permits you to withdraw your money after reaching that age, which most plans do.
In withdrawing money from a traditional IRA to put it into a Roth IRA, the entire amount you convert is taxable.
Converting to Roth probably doesn’t make sense while you’re still earning your normal income because doing so adds to your current taxable income. As a result, you will probably pay more taxes than if you wait until after you retire. Converting while you’re still working also reduces the size of your retirement nest egg by the amount of the taxes you pay.
Investment advisors often suggest converting to Roth after the value of your investments drops substantially. This enables you to avoid paying taxes on the investment gains after the market recovers. This is worth considering; however, seeing your retirement account drop by 50 percent is hard to accept. Eating further into your savings by paying tax on the balance you transfer to a Roth IRA makes it even more unpleasant.
If your $100,000 in your IRA becomes just $50,000, you may think investing in a Roth IRA will help mitigate your losses. The tax would be $11,000 assuming a 22 percent tax rate, leaving you with $39,000. It would take a 250 percent increase to get back to $100,000. This may not be a bad idea, but it takes some guts to pay the taxes a conversion requires.
Your employer may permit you to convert pre-tax money in your 401(k) account to Roth money. This would be a Roth conversion inside the 401(k) because the money stays in the 401(k) after the conversion. If so, you must pay taxes on the amount converted even though the money stays in the plan, and you can’t use money in the account to pay those taxes — you need to use money from outside the plan. So, if you convert $10,000 of the pre-tax money in your account to Roth, you pay tax on the whole $10,000.
However, if you’re over age 59½, you can withdraw money from your 401(k) unless your plan doesn’t permit this. In this instance, you can use a portion of the amount withdrawn to pay the taxes resulting from the conversion.
The best way to do a Roth conversion when you withdraw money from a 401(k) is via a trustee-to-custodian transfer directly into your Roth IRA. This means the money goes directly from your plan account to the custodian of your IRA. Use an existing Roth IRA if you have one because this eliminates the need to wait at least five years before you’re able to withdraw money from the account without a tax penalty.
You can make any number of Roth conversions, so you can convert smaller amounts over several tax years rather than doing a one-shot conversion.
You can make only one rollover from an IRA to another (or the same) IRA in any 12-month period regardless of the number of IRAs you own, with a few exceptions. See Chapter 10 for more details on rollovers.
If you’re thinking of doing more than a standard rollover or conversion, talk to a financial advisor or check the IRS resource guide at www.irs.gov/retirement-plans/ira-online-resource-guide to make sure what you plan to do is permitted. You may have to pay a big penalty if you mess up.